Chapter 18 - Solution Manual

Chapter 18 - Integrated Audits Audits of Public Companies

CHAPTER 18

Integrated Audits Audits of Public Companies

Review Questions

18-1

Section Section 404a 404a requires requires that that each each annual annual report report filed filed with the Securi Securities ties and and !chang !changee Commissio Commission n include an internal control report prepared b" management in which management ac#nowledges its responsibilit" for establishing and maintaining adequate internal control and an assessment of internal control effecti$e as of the end of the most recent fiscal year % year % Section 404b 404b requires requires that the CPA firm attest to and report on the assessment made b" management as well as pro$ide its own opinion on internal control%

18-&

As operatio operationali nali'ed 'ed b" the Securit Securities ies and and !change !change Comm Commissio ission( n( managemen management)s t)s four o$eral o$eralll responsibilities responsibilities relating to internal control o$er financial reporting *hereafter( internal control+, • • • •

18-

Accept responsibilit" for the effecti$eness of internal control% $aluate the effecti$eness of internal control using suitable control criteria% Support the e$aluation with sufficient e$idence% Pro$ide a report on internal control%

.he followi following ng inform information ation must be be included included in managem management) ent)ss report report on internal internal contro controll o$er financial reporting, •

• •

•

State that it is management)s responsibilit" responsibilit" to establish and maintain adequate internal control% Identif" management)s framewor# for e$aluating internal control% Include management)s assessment assessment of the effecti$eness of the compan") co mpan")ss internal control o$er financial reporting as of the the end of the most recent fiscal period( including a statement as to whether internal control o$er financial reporting is effecti$e% Include a statement that the compan")s auditors ha$e issued an attestation report on management)s assessment%

18-1

Chapter 18 - Integrated Audits of Public Companies

18-4

A material wea#ness is considered more serious% A material wea#ness is a deficienc"( or a combination of deficiencies( in internal control o$er financial reporting( such that there is a reasonable possibilit" that a material misstatement of the compan")s annual or interim financial statements will not be pre$ented or detected on a timel" basis% A significant deficienc" is a deficienc"( or a combination of deficiencies( in internal control o$er financial reporting that is less se$ere than a material wea#ness( "et important enough to merit attention b" those responsible for o$ersight of the compan")s financial reporting%

18-/

hile the first part is correct *both significant deficiencies and material wea#nesses must be communicated to the audit committee+( there is an important distinction between the two% aterial wea#nesses result in ad$erse internal control audit reports( while significant deficiencies do not% Considering definitions( a material wea#ness is a deficienc"( or a combination of deficiencies( in internal control o$er financial reporting( such that there is a reasonable possibilit" that a material misstatement of the compan")s annual or interim financial statements will not be pre$ented or detected on a timel" basis% A significant deficienc" is a deficienc"( or a combination of deficiencies( in internal control o$er financial reporting that is less se$ere than a material wea#ness( "et important enough to merit attention b" those responsible for o$ersight of the compan")s financial reporting%

18-2

hen reporting on internal control o$er financial reporting( the opinion is on whether internal control is effecti$e 3as of a particular date( ordinaril" the last da" of the client)s fiscal "ear% .his is in contrast to reporting on the effecti$eness of internal control o$er the entire "ear%

18-5

A compensating control limits the e!posure to misstatements that e!ists due to deficiencies in other controls% It 3compensates for the deficienc" in other controls( that is( it addresses the ob6ecti$e that is not being met b" the deficient control% Compensating controls are ordinaril" controls performed to detect( rather than pre$ent( a misstatement from occurring% 7or e!ample( a reconciliation of the ban# account performed b" an indi$idual otherwise independent of the cash function ser$es to detect a $ariet" of possible misstatements *both errors and fraud+ that ma" ha$e occurred in the processing of cash receipts and disbursements%

18-8

Antifraud programs * required+ include effecti$e, • • • • • •

anagement accountabilit"% Audit committee% Code of conductethics% 3histleblower program% 9iring and promotion procedures% :emediation of significant deficiencies material wea#nesses( and fraud%

Students ma" include additional programs and elements% 18-;

A wal#-through in$ol$es literall" tracing a transaction though the entire information s"stem from inception to financial reporting% Although generall" an effecti$e approach( wal#-throughs are not required during an audit of internal control o$er financial reporting% .he" ma" be performed b" the auditors or b" the client personnel under proper super$ision of the auditors%

18-&


18-10 Although an" number of inquiries ma" be made( inquiries such as the following are suggested * required+, Can "ou describe the part of the processing of the transaction with which "ou are in$ol$ed< hat do "ou do when "ou find an error< • hat #ind of errors ha$e "ou found< • hat happened as a result of finding the errors( and how were the errors resol$ed< • 9a$e "ou e$er been as#ed to o$erride the process or controls< If "es( wh" did it occur • and what happened< al#throughs pro$ide the auditors with e$idence to, =erif" that the" ha$e identified points at which a significant ris# of misstatement to a • rele$ant assertion e!ists% =erif" their understanding of the design of controls( including those related to the • pre$ention or detection of fraud% $aluate the effecti$eness of the design of controls% • Confirm whether controls ha$e been place in operation *implemented+% • •

18-11

18-1& Routine transactions are for recurring acti$ities( such as sales( purchases( cash receipts and disbursements( and pa"roll% Nonroutine transactions occur onl" periodicall"( such as the ta#ing of ph"sical in$entor"( calculating depreciation e!pense or ad6usting for foreign currencies> nonroutine transactions generall" are not a part of the routine flow of transactions% Estimation transactions *sometimes referred to as nonsystematic transactions + are acti$ities in$ol$ing management)s 6udgments or assumptions( such as determining the allowance for doubtful accounts( establishing warrant" reser$es( and assessing assets for impairment% 18-1 An account is significant if there is more than a remote li#elihood that it could contain misstatements that indi$iduall"( or when aggregated with others( could ha$e a material effect on the financial statements% 7actors that should be considered in deciding whether an account is significant include its, • • • • • • • • •

Si'e and composition% Susceptibilit" of loss due to errors or fraud% =olume of acti$it"( comple!it" and homogeneit" of indi$idual transactions% ?ature of the account% Accounting and reporting comple!it"% !posure to losses% @i#elihood of significant contingent liabilities !istence of related part" transactions% Changes from the prior period%

18-


18-14 hether the auditors must perform tests at each location depends upon the indi$idual importance of each location% .ests need onl" be performed at locations *or business units+ that( indi$iduall" or when aggregated( could create a material misstatement of the financial statements% 18-1/

.he statement is incorrect because auditors must first test design effecti$eness( and if the design seems appropriate( test operating effecti$eness to determine whether it is functioning properl"% It is not a choice of one $ersus the other( although tests of operating effecti$eness will not ordinaril" be performed when the design is ineffecti$e%

18-12 An" number of possible e!amples ma" be gi$en in response to the question% ne e!ample is when a control is designed to require two indi$iduals to open each da")s cash receipts% It ma" not operate effecti$el" when the compan" allows one person to perform the function on da"s in which the second person is needed to perform another function% Also( such a control ma" not operate effecti$el" if the two indi$iduals simpl" di$ide the 6ob in half and perform the function independentl" of one another% 18-15 .he statement is correct% Standard ?o% / requires that additional e$idence be"ond inquir" alone be gathered% .hus( the auditors should substantiate inquir" results to the e!tent possible b" performing other procedures such as inspecting reports or other documentation relating to the inquir"% 18-18 .he statement is incorrect in that some controls ma" be tested after the 3as of date *"ear-end+% A good e!ample are controls o$er the period-end financial reporting process in that the" often function after "ear-end when the financial statements are being prepared% 18-1; .he auditors ma" use the wor# of others as a part of an audit of internal control% ne would ordinaril" e!pect that the wor# of others would in$ol$e testing more low-ris#( routine transactions rather than per$asi$e and control en$ironment controls% In all cases in which the wor# of others is going to be used( the auditors should e$aluate the competence and ob6ecti$it" of those indi$iduals and test the wor# the" ha$e performed% 18-&0

hen a substanti$e procedure identifies a misstatement( this will ordinaril" indicate that controls ha$e not operated effecti$el"% Accordingl"( this ma" lead to a consideration of the circumstances and whether a brea#down in controls indicates the e!istence of a significant deficienc" or a material wea#ness% Indeed( identification of a material misstatement in the current "ear financial statements that was not initiall" identified b" the compan")s internal control is considered at least a significant deficienc" and a strong indicator of a material wea#ness%

18-&1 .he performance of substanti$e tests ma" be affected b" tests of controls in circumstances in which a control deficienc" is identified% Substanti$e procedures ma" be increased to identif" an" possible material misstatement% 18-&& ntit"-le$el controls ha$e a per$asi$e effect on the achie$ement of o$erall control ob6ecti$es *e%g%( tone at the top+ rather than a specific control ob6ecti$e%

18-4


18-& .he following represents transactions that are indicators of material wea#nesses in internal control *three required+, Identification of fraud( whether or not material( on the part of senior management • :estatement of pre$iousl" issued financial statements to reflect the correction of a • material misstatement% Identification b" the auditor of a material misstatement in circumstances that indicate that • the misstatement would not ha$e been detected b" the compan") internal control% Ineffecti$e o$ersight of the compan")s e!ternal financial reporting and internal control b" • the compan")s audit committee% 18-&4 .he opinion paragraph concludes directl" on internal control% 18-&/ A management imposed scope limitation is most li#el" to result in a disclaimer of opinion on the compan")s internal control o$er financial reporting( or possibl" withdrawal from the engagement% 18-&2

Bes( although a material wea#ness e!ists related to internal control( the financial statements ma" still follow generall" accepted accounting principles and an unqualified audit report ma" be appropriate% 7or e!ample( a material wea#ness ma" ha$e been identified( but one which the auditors) substanti$e tests determined did not lead to a material misstatement during the "ear under audit% r( if a material misstatement did occur during the "ear under audit and management has corrected it( an unqualified audit report on the financial statements would also be appropriate%

18-&5 Auditors must communicate both significant deficiencies and material wea#nesses to the audit committee% 18-&8 hen the auditors are engaged to report on whether a pre$iousl" reported material wea#ness continues to e!ist( the" plan and perform an engagement the focuses on controls that are rele$ant to the particular wea#ness% If the" determine that the controls are now effecti$e( the auditors ma" issue an unqualified report indicating that the material wea#ness no longer e!ists%

18-/


Questions Reuiring Anal!sis

18-&;

7igure 18%5 presents the $arious lin#s between identif"ing significant accounts and the controls to be tested% .hat sequence in$ol$es the following steps, 1%

Identify significant accounts and disclosures % Significant accounts and disclosures are those in which there is more than a remote li#elihood that it could contain misstatements that indi$iduall"( or when aggregated with others( could ha$e a material effect on the financial statements%

&%

Identify relevant financial statement assertions. .he financial statement assertions for significant accounts are, *1+ e!istence or occurrence> *&+ completeness> *+ $aluation or allocation> *4+ rights and obligations> */+ presentation and disclosures% .he rele$ant assertions are those that ha$e a meaningful bearing on whether the account is presented fairl"%

%

Identify significant processes and major classes of transactions. .he auditors identif" each significant process o$er each ma6or class of transactions% a6or classes of transactions are those groupings of transactions that are significant to the financial statements% Consider a compan" whose sales ma" be initiated b" customers either through the Internet( or in a retail store% .hese t"pes of sales represent two ma6or classes of transactions within the sales processes% Also( for a compan" with a significant amount of fi!ed assets( recording depreciation is a process that creates a ma6or class of transactions% hen auditors consider the ma6or classes of transactions it is helpful to classif" them b" what Standard ?o% / refers to as transaction type routine( nonroutine( or estimation% 7or each significant process( the auditors should, •

•

Identif" points at which a misstatement could arise%

•

Identif" controls to address potential misstatements%

•

4%

Dnderstand the flow of transactions *initiation( authori'ation( recording processing( reporting+%

Identif" controls to pre$ent or timel" detect unauthori'ed acquisition( use or disposition of the compan")s assets%

Identify control objectives% .he control ob6ecti$es relate to the specific process in question% 7igure 18%; pro$ides an illustration for accounts recei$able% .he control ob6ecti$es include, •

nsure that all goods shipped are accuratel" billed in the proper period%

•

Accuratel" record all authori'ed shipments and onl" such shipments%

•

Accuratel" record all authori'ed sales returns and allowances and onl" such returns and allowances%

•

nsure continued completeness and accurac" of accounts recei$able%

•

Safeguard accounts recei$able records%

18-2


/%

Identify controls to test. .he auditors identif" the controls to be tested b" considering the, • •

18-0 *a+

18-1

Points at which errors or fraud could occur% ?ature of the controls implemented b" management%

•

Significance of each control in achie$ing the ob6ecti$es of the control criteria%

•

:is# that controls might not be operating effecti$el"

.he ob6ecti$e of tests of controls in an audit of internal control is to obtain e$idence about the effecti$eness of controls to support the auditors) opinion on whether management)s assessment of the effecti$eness of internal control is fairl" stated as of a point in time and taken as a whole. Accordingl"( to e!press this opinion the auditors must obtain e$idence about the effecti$eness of controls o$er all rele$ant assertions for all significant accounts and disclosures in the financial statements% .his results in both testing controls not ordinaril" tested for a financial statement and emphasi'ing tests that bear on their effecti$eness as of a point in time"ear-end%

*b+

.he ob6ecti$es of tests of controls for financial statement audits is to assist the auditors in planning the audit and to assess control ris#% .o assess control ris# at less than the ma!imum( the auditors are required to obtain e$idence that the rele$ant controls operated effecti$el" during the entire period upon which the auditors plan to place reliance on those controls% 9owe$er( the auditors are not required to assess control ris# at less than the ma!imum for all assertions%

*c+

.o reconcile these approaches( Standard ?o% /( for purposes of the internal control audit( allows the auditors to obtain e$idence about operating effecti$eness at different times throughout the "earpro$ided that the auditors update those tests or obtain other e$idence that the controls still operated effecti$el" at the end of the "ear% .hus( although the timing for issuing the internal control report would often not require tests throughout the "ear( the integrated nature of the two audits suggests a degree of testing throughout the "ear%

*a+ the

.he management of Ale!andria must gather sufficient e$idence to demonstrate that hiring controller has eliminated the material wea#ness( document the e$idence( and pro$ide a written assertion that the material wea#ness no longer e!ists%

*b+

ebster( arren E ebb should plan and perform an engagement the focuses on whether the new controller has sufficient e!pertise to eliminate the material wea#ness% If the" determine that hiring the controller has mitigated the wea#ness( the auditors ma" issue an unqualified report indicating that the material wea#ness no longer e!ists%

18-5


*c+

If the audit team disco$ers another wea#ness during the course of the audit( it will not

affect the auditors) report% 9owe$er( the" should ma#e sure that the audit committee of Ale!andria is notified about the wea#ness% "b#ective Questions

18-& ultiple Choice *a+

*1+

PCAF Standard ?o% / requires that the auditors to communicate both material wea#nesses and significant deficiencies to the audit committee%

*b+

*&+

An audit report on internal control is modified for material wea#nesses( not significant deficiencies%

*c+

*1+

anagement must communicate both material wea#nesses and significant deficiencies to the audit committee%

*d+ *1+ the control%

PCAF Standard ?o% / includes Ineffecti$e o$ersight of financial reporting b" audit committee is considered an indicator of a material wea#ness in internal

*e+

*&+

A material wea#ness in$ol$es a reasonable possibilit" of a material misstatement%

*f+

*+

An unqualified opinion with no e!planator" language is appropriate when the material wea#ness has been eliminated *remediated+ prior to the 3as of date( "ear-end%

*g+

*4+

anagement)s report on internal control under Section 404a of the Sarbanes-

!le" Act of &00& need not state that it has a responsibilit" to establish and maintain internal control that detects all significant deficiencies % *h+

*&+

anagement)s documentation must include information on controls designed to pre$ent fraud( but not on controls designed to ensure emplo"ee personal integrit"%

*i+

*4+

A material wea#ness in$ol$es a material amount%

*6+

*4+ A wal#-through in$ol$es tracing a transaction from origination through a compan")s information s"stems until it is reflected in the financial reporting s"stem%

*#+

*+

Auditors will not ordinaril" as# what was the largest fraudulent transaction an indi$idual e$er processed% .he other three replies are recommended questions%

18-8


*l+

*1+

An audit of internal control o$er financial reporting ordinaril" assess internal

control at an 3as of dateordinaril" the last da" of the fiscal period% 18- 1%

*A+

.he function of a credit department is to follow the compan")s credit policies to ma#e decisions on the granting of credit%

&%

*F+

Sales returns should be presented to the recei$ing cler# *not a sales department cler#+ who should prepare a recei$ing report *not a shipping report+%

%

*A+

Sending monthl" statements to customers represents a control strength as errors and fraud ma" be disco$ered%

4%

*F+

rite-offs of accounts recei$able should be appro$ed b" a management official independent of the record#eeping function( not b" the controller who is responsible for record#eeping% 7requentl"( the treasurer appro$es write-offs%

/%

*C+

hile requiring two signatures on large chec#s is a good control o$er e!penditures( it relates much more directl" to the purchasesdisbursements c"cle than to the re$enue c"cle%

2%

*A+

ailed cash receipts should be recei$ed b" an indi$idual with no record#eeping responsibilit"a secretar" with no record#eeping responsibilit" is appropriate% .hat indi$idual should open the mail and prepare a list of the receipts% .he cash should be forwarded with a cop" of the listed receipts to a cashier *or the indi$idual who ma#es deposits+ and the remittance ad$ices should be forwarded with another cop" of the listed receipts to the accounting department%

5%

*F+

As indicated in the answer e!planation to item 2( the cash receipts should be opened b" an indi$idual with no record#eeping responsibilit"% .he cash should be forwarded with a cop" of the listed receipts to a cashier *or the indi$idual who ma#es deposits+ and the remittance ad$ices should be forwarded with another cop" of the listed receipts to the accounting department%

8%

*F+

.he cash receipts 6ournal should be prepared b" the department responsible for record#eepingaccountingunder the authorit" of the controller%

;%

*F+

Cash should ordinaril" be deposited dail"%

10% *C+

.his control relates to the purchasesdisbursements c"cle%

11% *A+

Fan# reconciliations should be prepared b" indi$iduals independent of cash receipts *and cash disbursements+ record#eeping%

18-;


18-4 Simulation *a+ *b+ *c+ *d+ *e+ *f+ *g+

*h+

Agree% =oided chec#s should be sa$ed so there is no question as to whether it is $oided or outstanding% Gisagree% ach ban# account ordinaril" has its own series% Agree% Purchasing( which authori'es purchase( should not also sign chec#s( which in essence disburse funds related to those purchases% Agree% Chec#s ma" be made pa"able to cash ma" be cashed b" an inappropriate person% Agree% Authori'ed chec# signers disburse funds and effecti$e o$ersight of the disbursement function requires reconciliation b" another indi$idual% Gisagree% Cash receipts should be so prelisted to establish control o$er total receipts% Gisagree% A polic" of restricti$el" endorsing receipt *e%g%( endorsing them 3pa" onl" to Habling Co%+ is a control that ma#es it more difficult for another indi$idual to cash the chec#s for personal use% Gisagree% .his polic" eliminates the possibilit" of the support inappropriatel" being used to support an improper second disbursement using those documents%%

18-/ *a+ *b+ *c+ *d+ *e+ *f+

4 1 ; 8  1&

aterial wea#ness Control deficienc" Significant account Section 404 a6or classes of transactions al#-through

Problem

18-2

S@D.I?, Slingsdale Fuilding Supplies( Inc% *stimated time, 0 minutes+ *a+ .he following deficiencies e!ist in Slingsdale)s cash receipts and billing functions,  Credit manager, o

Abilit" to appro$e credit without e!ternal credit chec# or reference to established credit limits

 A: super$isor,

18-10


o o

o o

o

Filling without independent manual or computer $erification% Abilit" to alter details of charge forms and to use altered details in preparing in$oices% ?o chec# that dail" totals of charge forms equal dail" totals of in$oices% a" write off accounts because there is no independent $erification of the A: subsidiar" ledger or reconciliation of it with the control account% @ong o$erdue accounts ma" remain on boo#s and additional credit granted b" omitting them from monthl" report%

 Cashier, o

o o

Incompatible duties of recei$ing cash receipts( depositing cash( and recording receipts on remittance ad$ices% ?o independent $erification of cash receipts with deposit slips or lists of chec#s% :econciling ban# statements is incompatible with recei$ing and depositing cash%

 Foo##eeper, o o

o

o

Authori'es write-offs without in$estigating reasons for them% stablished criterion for write-offs is too infle!ible and does not pre$ent granting additional credit at earlier date% Can indirectl" grant additional credit b" not notif"ing credit manager of writeoff% Incompatible duties of authori'ing and recording write-offs%

*b+

aterial wea#nesses result in an ad$erse opinion%

*c+

All material wea#nesses and significant deficiencies must be reported both to management and to the audit committee%

In$Class Team Case

18-5

S@D.I?, Control Geficiencies( Significant Geficiencies and aterial ea#nesses *stimated .ime--0 minutes+ Case 1 .he auditors would generall" determine that this deficienc" represents a significant deficienc" because while an immaterial amount is li#el" to be in$ol$ed( it does seem large enough as to merit informing those responsible for o$ersight of the compan")s financial reporting%

18-11


Case & .he auditors are most li#el" to determine that the combination of these significant deficiencies represents a material wea#ness for the following reasons, • Indi$iduall"( these deficiencies were e$aluated as representing significant deficiencies% • ach of these significant deficiencies affects the same set of accounts and ta#en together ma" represent a more than remote li#elihood that a material misstatement could occur and not be pre$ented or detected% .herefore( in combination( these significant deficiencies ma" represent a material wea#ness%

Case  .he auditors are most li#el" to determine that a significant deficienc" for the following reasons, .he magnitude of a financial statement misstatement resulting from this deficienc" would • reasonabl" be e!pected to be less than material( although at a le$el that might merit the attention of those responsible for o$ersight of the compan")s financial reporting% .he ris# of material misstatement is limited to re$enue recognition errors related to • shipping terms as opposed to broader sources of error in re$enue recognition% 9owe$er( the compensating detecti$e controls are onl" designed to detect material misstatements% Case 4 Fased on onl" these facts( the auditors should determine that this deficienc" represents a material wea#ness for the following reasons, .he magnitude of a financial statement misstatement resulting from this deficienc" • would reasonabl" be e!pected to be material( because the frequenc" of occurrence allows insignificant amounts to become material in the aggregate% .he li#elihood of material misstatement of the financial statements resulting from this • internal control deficienc" is reasonabl" possible *e$en assuming that the amounts were full" reser$ed for in the compan"Js allowance for uncollectible accounts+ due to the li#elihood of material misstatement of the gross accounts recei$able balance% .herefore( this internal control deficienc" meets the definition of a material wea#ness% Case / A restatement of pre$iousl" issued financial statements to reflect the correction of a misstatement should be regarded as at least a significant deficienc" and a strong indicator that a material wea#ness in internal control o$er financial reporting e!ists% If the auditors belie$e that management now #nows the rules this ma" be considered onl" a significant deficienc" assuming the auditors don)t belie$e that this lac# of accounting #nowledge is a general problem in other areas%

18-1&


Case 2 .he auditor)s identification of a material misstatement is an indicator of a material in internal control% Bet( the hiring of the financial accounting e!pert seems to indicate that the deficienc" does not e!ist at "ear-end% It seems clear that a material wea#ness in internal control does not e!ist at "ear-end% Case 5 .he question here relates to whether the auditor belie$es that the chief financial officer)s #nowledge and abilit" is sufficient to indicate that neither a material wea#ness nor a significant deficienc" e!ists at "ear-end% .he auditors would need to determine whether the chief financial officer is li#el" to be able to effecti$el" monitor matters% If not( a material wea#ness would seem to e!ist%

Case 8 PCAF Standard ?o / states that identification b" the auditor of a material misstatement in financial statements in the current period that was not initiall" identified b" the compan")s internal control o$er financial reporting is a strong indicator of a material wea#ness% Fecause the auditors belie$e that the controller)s estimate is not reasonable( this would appear to be a strong indicate that a material wea#ness in internal control o$er financial reporting e!ists%

18-1

Chapter 18 - Solution Manual

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